FOOL SCHOOL
Exceptional Items

November 19, 2001

Read any set of company results and you're bound to stumble across "exceptional items". While chief executives tend to gloss over them, investors should always investigate these charges. They are a true economic cost to shareholders and should be taken into account when assessing any business.

Definition

Financial Reporting Standard 3 defines exceptional items as

"... material items which derive from events or transactions that fall within the ordinary activities of the business and which need to be disclosed by virtue of their size or incidence if the financial statements are to give a true and fair view."

In other words, they're large and unusual items derived from the day-to-day activities of the company.

The two most frequent types of exceptional items are:

* Costs associated with a fundamental company reorganisation, merger or acquisition, and;
* Profits or losses relating to the sale or termination of an operation, or the disposal of fixed assets;

British Telecom (LSE: BT.A), for example, provided a wide range of exceptional items in its latest full-year results. BT's pre-exceptional, pre-tax profits had amounted to £2b, a figure subsequently wiped out by the following costs:

                                                                    Year
                                                               ended March 31,
                                                                 2001     2000
                                                                   £m       £m
 
Impairment of goodwill in Viag Interkom                        (3,000)       -
Impairment of goodwill in ventures                               (200)       -
Write off of cellular subscriber acquisition costs               (139)       -
Write off of Viag Interkom's IT systems                           (43)       -
Infrastructure rates refunds                                       193       -
Costs relating to the disengagement from MCI                         -    (64)
Costs relating to the closure of the BT Cellnet analogue             -    (47)
network
Adverse impact on total operating profit                       (3,189)   (111)
Profit on sale of group undertakings                               619     126
Interest receivable on rates refunds                                25       -
Beneficial (adverse) impact on profit before tax               (2,545)      15

Approach with caution

So, how should private investors approach such accounting entries? There are two points to consider:

1) The inherent lumpiness of exceptional items:

Take BT's £3b write-off of its recent Viag Interkom investment, a charge caused by the "reduced expectations for the rate of growth in profits [at Viag Interkom] in the medium term".

While perfectly acceptable for BT to levy the £3b all in one go, the charge heavily distorts this year's profits. To get a better picture of "underlying profits", investors ought to spread any lumpy charge over the timescale it relates to. So, in BT's case, that £3b would be divided over the next few years (i.e. BT's "medium term").

Similarly, when an exceptional item relating to activities of the past is charged, shareholders ought to revisit the company's financial record. Do those historic profits still present a fair picture?

Not so exceptional

2) The recurring exceptional item:

Companies with the habit of presenting exceptional items on a regular basis ought to be treated with suspicion. Look at Diageo (LSE: DGE), whose financial record is shown below. Not a year goes by without a bunch of exceptional items emerging at the drinks firm.

Year to 30th June         1997    1998    1999    2000

Pre-exceptional
Operating Profit (£m)    2,003   1,942   1,903   1,980 

Exceptional Items (£m)     642     167     296     347 

Such regularity clearly puts the usefulness of Diageo's pre-exceptional profit figures into doubt.

Summary

When encountering exceptional items:

* Consider what profit adjustments would be required if the exceptional item was spread over the timescale it related to. Significant exceptional charges could be a distraction from past or future profit problems; and

* Be suspicious of companies who present significant, regular exceptional items, and;

Unfortunately, there's no magic formula when evaluating exceptional items. As in most aspects of investment, judging exceptional items is an art learned from experience. But as stated earlier, exceptional items are a true economic cost to shareholders and should always be considered when assessing any business.